August 19, 2020
Taxable REIT Subsidiary not treated as operating or managing a health care facility
In PLR 202029002, the IRS ruled that a taxable REIT subsidiary (TRS) will not be considered to be operating or managing a health care facility in violation of IRC Section 856(l)(3)(A), an activity that otherwise would result in the loss of TRS status.
Taxpayer, a corporation that has elected to be taxed as a real estate investment trust (REIT), owns senior housing and health care properties.
Taxpayer owns a corporate subsidiary (Subsidiary) that currently qualifies as a TRS of Taxpayer under IRC Section 856(l). Subsidiary intends to purchase a limited partnership interest in Fund and an undisclosed amount of stock of a corporation (GP) that is the general partner of Fund (the Acquisition).
Fund is a limited partner in subsidiary partnerships (Sub LPs), each of which owns health care communities (Communities) that constitute "qualified health care properties" under IRC Section 856(e)(6)(D). A corporate subsidiary of GP (Sub GP) is the general partner of each Sub LP. GP and Sub GP have all management rights with respect to Fund and Sub LPs, respectively. While not explicitly stated in the ruling, it appears the Communities are located outside the United States.
Upon the Acquisition, each Sub LP will enter into a new management contract with the existing Operator to manage the day-to-day operations of each Community owned by the Sub LP. Each Sub LP will continue to employ the employees working at the Community (Community Employees); however, all employees with supervisory roles over Community Employees will be employed by Operator. Operator will have the exclusive authority to supervise and control Community Employees of each Community, including the exclusive right and responsibility to recruit, train, supervise, hire and terminate all employees at all levels, irrespective of the identity of the legal employer. This employment structure was in place before the Acquisition.
Operator qualifies as an independent contractor (IK) (from whom Taxpayer receives no income) under IRC Section 856(d)(3).
Subsidiary will not be involved in any day-to-day operations of, or services provided at, the Communities.
Law and analysis
IRC Section 856(c)(2) requires a REIT to derive at least 95% of its gross income from specific sources, including rents from real property, and IRC Section 856(c)(3) requires a REIT to derive at least 75% of its gross income from specified sources, including rents from real property.
The term "rents from real property" includes, among other things, rents received from the lease of interests in real property to tenants (IRC Section 856(d)(1)), but does not include: (1) rents based on the income or profits of a tenant, (2) rents received from certain related-party tenants and (3) impermissible tenant services income (IRC Section 856(d)(2)).
Under IRC Section 856(d)(7)(A), impermissible tenant services income (ITSI) includes amounts that a REIT receives for furnishing services to tenants of its property, or for managing or operating the property. IRC Section 856(d)(7)(C)(i), however, excludes from ITSI amounts received by the REIT for services, management or operation provided through (1) an IK from which the REIT does not derive or receive any income or (2) a TRS. More specifically, IRC Section 856(d)(7)(C)(i) does not treat services, management or operation as "furnished, rendered, or provided by the REIT" if provided through (1) an IK from which the REIT itself does not derive or receive any income or (2) a TRS.
IRC Section 856(l)(1) defines a TRS as a corporation whose stock is directly or indirectly owned, in full or part, by a REIT and that jointly elects with the REIT to be treated as a TRS. A corporation will not qualify as a TRS, however, if it directly or indirectly "operates or manages a lodging facility or a health care facility" (IRC Section 856(l)(3)).
IRC Section 856(d)(8)(B) contains an exception to the related-party rent rule of IRC Section 856(d)(2)(B) if a REIT leases a qualified lodging facility or a qualified health care property to a TRS and the property is "operated on behalf of the TRS" by a person that qualifies as an eligible independent contractor (EIK). IRC Section 856(d)(8)(B)(ii) does not consider a TRS to be operating or managing a qualified lodging facility or qualified health care property solely because the TRS employs individuals working at such a property outside the United States, provided the "EIK is responsible for the daily supervision and direction of such individuals on behalf of the TRS pursuant to a management agreement or similar service contract."
In its analysis, the IRS first said that IRC Section 856 does not prohibit Subsidiary from owning a health care facility, such as a Community, but Subsidiary will not qualify as a TRS if it "operates or manages" a health care facility such as a Community.
The IRS explained that Subsidiary has no direct involvement in the management of the Communities (e.g., no legal or contractual rights to participate in the daily operation of the Communities). Rather, Operator, an IK with respect to Taxpayer, has the "exclusive authority to supervise and direct the employees of each Sub LP."
The IRS next addressed the fact that the Community employees will be employees of a Sub LP (as contrasted with being Operator's employees). The IRS indicated that IRC Section 856(d)(8)(B)(ii) "establishes that mere legal employment of an individual working in a qualified health care property is not, per se, operation of the qualified health care property." The IRS added that the "Community Employees will be part of an arrangement similar to that described in IRC Section 856(d)(8)(B)(ii), in which employees of a TRS are supervised by an EIK." In this case, however, the Community Employees will not be Subsidiary's employees, but rather employees of the Sub LPs, which are limited partnerships "with respect to which Sub GP has all management rights."
Based on the facts and representations, the IRS ruled that Subsidiary will not be considered to be directly or indirectly operating or managing a health care facility within the meaning of IRC Section 856(l)(3)(A).
PLR 202029002 gives insight into the IRS's interpretation of IRC Section 856(l)(3)(A), which prohibits a TRS from directly or indirectly operating or managing a lodging facility or a health care facility.
The IRS acknowledged that a TRS would not be treated as operating or managing a health care facility solely because it used an IK, rather than an EIK (which is necessary for purposes of the related-party-rent exception of IRC Section 856(d)(8)(B)), to operate and manage the health care property (which the TRS owns through a partnership). It appears the IRS took comfort in the language of IRC Section 856(d)(7)(C)(ii), which provides that services and operation provided through an IK (from which the REIT does not derive or receive any income) "shall not be treated as furnished, rendered, or provided by the REIT." See PLR 201533006, which also approved of the use of an IK in a similar situation.
PLR 202029002 is also of interest because the IRS did not treat a TRS as operating or managing a health care facility solely because its partnership employs community-level employees (rather than an IK employing such employees). In reaching that conclusion, the IRS noted that the IK will employ all employees with supervisory roles and have exclusive authority to supervise and control the community employees. See PLR 201208014, which also approved of employment of property-level employees by a partnership in which the TRS was a partner. The determination of whether a TRS is directly or indirectly operating or managing a health care facility or a lodging facility in many situations is highly factual so taxpayers should be careful of trying to draw broad conclusions from these PLRs.